Introduction

Sometimes a policyholder and plaintiff may settle their differences by resolving their liability dispute and then successfully suing a defaulting insurer to win a coverage dispute in a two part procedure we call Settle and Sue. Standard liability policy provisions confer upon a performing insurer the right to control settlement.[1] However, a defaulting insurer may be precluded from enforcing such provisions.[2] A policyholder whose insurer is not faithfully providing a defense may cooperate with the plaintiff[3] and negotiate a settlement[4] over the objection of the insurer.[5] But even an insurer that has wrongfully abandoned its policyholder is entitled to assert a limited defense of collusion.[6] “In no other way can the courts give any meaningful protection to an insured who is abandoned by a liability insurer wrongfully denying coverage or refusing a defense and at the same time provide to the insurer some measure of procedural due process in order to protect against the consequences of a fraudulent or collusive settlement.”[7]

Should the Policyholder and Plaintiff Cooperate?

Many civil lawsuits are motivated by money and vengeance.[8] Vengeance is very difficult to achieve in the court system since the overwhelming majority of cases settle. Settlement rarely determines who was “right” and who was “wrong” nor does either the plaintiff or the policyholder emerge from litigation with a sense of victory. However, the courts are very effective at redistributing money. If a policyholder or a plaintiff insist on vengeance, it is unlikely that they may choose to cooperate with each other. But if a policyholder and a plaintiff seek prompt closure and an equitable settlement at an insurer’s expense, they may choose to cooperate.

Many policyholders and plaintiffs mistakenly assume that they may not possibly cooperate with one another for the simple reason that they are adversaries in a liability dispute. However, when an insurer disclaims coverage, the policyholder and the plaintiff share goals in a simultaneous coverage dispute. Thus, California law is clear that cooperation between a plaintiff and a policyholder to protect their common interests in a coverage dispute is perfectly proper. Nonetheless, iInsurer’s and their lawyers frequently threaten that cooperation between a policyholder and a plaintiff constitutes collusion.[9] And certainly California courts will not tolerate fraud. “The principles of fraud and collusion are self-evident and require no extended discussion. The facts and circumstances which will lead a court to conclude that either are present are limited only by the imagination of those who would cheat and deceive.”[10] However, collusion is a well developed and very limited defense.[11] A review of all major California collusion cases provides clear guidance as to what is and is not permissible.[12] Accordingly, policyholders and plaintiffs who choose to cooperate may do so lawfully.

California law clearly defines limits of permissible cooperation.[13] Standard liability policies do include a cooperation clause,[14] the meaning of which may be easily discerned.[15] Significantly, no language in a standard liability policy prohibits the policyholder and the plaintiff from cooperating with each other. There are, of course, limits to such cooperation. Neither a policyholder nor a plaintiff may lie.[16] But a plaintiff may properly plead into coverage.[17] Both the policyholder and the plaintiff may truthfully testify into coverage.[18] Indeed, it is improper for an insurer or its lawyers to put up a sham defense.[19]

Is the Insurer Defending Properly

Policyholders and plaintiffs who choose to cooperate, nonetheless may not settle without the insurer’s consent unless the insurer is in default of its duty to defend. California law is clear that an insurer that wrongfully refuses to defend, abandoning its policyholder to fend for oneself may not enforce favorable policy provisions.[20] As a non-performing party to a contract of insurance, a defaulting insurer may not seek to compel the other party, the policyholder, to adhere to the terms of the contract. “If an insurer, with notice of the pendency of the underlying action, wrongfully denies coverage or improperly refuses to provide its insured with a defense, then ‘the insured is entitled to make a reasonable settlement of the claim in good faith and . . . then maintain an action against the insurer to recover the amount of the settlement.’”[21]

California law is also clear that an insurer that expresses agreement to defend but fails to faithfully pay for it is in breach of contract. Lip service does not satisfy the duty to defend. The insurer’s duty requires it “to provide counsel with adequate funds to conduct the defense of the suit.”[22]Reservation of rights “letters were only an expression of [the insurer]’s future intent to comply with its duty to defend, and not an actual acceptance or agreement to provide a defense or to appoint plaintiffs’ chosen counsel as Cumis counsel. [The insurer]’s payment of defense fees at the end of the litigation [was] the equivalent of a defense denial. [Any other rule] would encourage insurers to reject their Cumis obligations for as long as they chose.”[23]

However, there are no California reported opinions that litigate and decide whether a policyholder may settle with a plaintiff where the insurer agrees to defend but fails to pay for it.

How to Settle Without Insurer Consent

Every lawsuit is an unique as a snowflake. Policyholders and plaintiffs who choose to cooperate and who are satisfied that the insurer is wrongfully failing to provide a defense may also choose to exercise a well recognized option to settle without insurer consent on terms that include an assignment[24] by the policyholder to the plaintiff of all assignable rights[25] and grant a lien on all non-assignable rights.[26] While courts, insurers and their lawyers are highly suspicious of covenants not to execute because the policyholder has little incentive to vigorously resist a plaintiff’s claim,[27] such settlements may be enforced against defaulting insurers.[28] Indeed, California law is clear that such settlements create evidentiary presumptions that are quite favorable to the policyholder and the plaintiff.[29] When the policyholder and the plaintiff settle and sue, a rebuttable presumption may arise that: 1) the policyholder is legally liable to the plaintiff; and 2) the monetary amount of the policyholder’s liability to the plaintiff is established.

However, a settlement does not necessarily establish whether the insurer had a duty to defend or indemnify or whether it breached either duty. These determinations are usually made in an action by the policyholder and/or the plaintiff against a defaulting insurer.[30] “Obviously, to demonstrate the right to rely on such presumption, an insured should be required to establish certain basic or foundational facts. We believe they are three in number: (1) the insurer wrongfully failed or refused to provide coverage or a defense, (2) the insured thereafter entered into a settlement of the litigation which was (3) reasonable in the sense that it reflected an informed and good faith effort by the insured to resolve the claim. (Citations.) . . . The insured can satisfy its prima facie burden of showing that the settlement was reasonable by presenting the same kind of evidence which would support a determination of good faith under [Code Civ. Proc.] section 877.6. ‘Good faith,’ for purposes of section 877.6, requires ‘the trial court to inquire, among other things, whether the amount of the settlement is within the reasonable range of the settling tortfeasor’s proportional share of comparative liability . . . as well as the existence of collusion, fraud, or tortious conduct aimed to injure the interests of nonsettling defendants.’ If there has already been a determination of good faith made under section 877.6, then that fact would itself be substantial evidence of reasonableness and would be sufficient to satisfy the insured’s prima facie burden.”[31]

Should a Settlement Include an Arbitration?

A policyholder and plaintiff who choose to settle and sue may also decide whether to conduct an arbitration. When issues of liability and damages have been determined by an impartial judicial determination, the policyholder and the plaintiff may enjoy conclusive evidentiary presumptions[32] to which the insurer may not assert the defense of collusion.[33] “The farther down the continuum from contested judgment to voluntary payment the facts lie, the more difficult it will be to prove the existence of an ‘amount which the insureds are legally obligated to pay.”[34] An independent adjudication that litigates and resolves the issues of liability and damages is viewed as satisfying procedural due process to protect interests of the defaulting insurer and the interests of the court system to establish the bona fides of a settlement. A default judgment and an uncontested trial “in which the injured party was required to present some evidence, is sufficient to satisfy the ‘no action’ clause requirement of an ‘actual trial’ and would bind the insurer that had denied coverage or refused to provide a defense [but not] a good faith determination pursuant to section 877.6. That determination, however, may well have evidentiary value in the ultimate resolution of the bona fides of the settlement. ¶ [Due process must be served by] sufficient judicial oversight to make the resulting judgment binding on the defendant insurers.”[35] It appears that California courts respect impartial adjudications of liability disputes because the court system and society as a whole have a stake in the action such that even defaulting insurers are not stripped of all rights to avoid a collusive outcome of a liability dispute. As a result, the policyholder and the plaintiff must always have their day in court to establish the bond fides of a settlement.

What Is the Impact of Two Lawsuits?

When an injured plaintiff hires a lawyer to seek redress, a practical consideration that a plaintiff’s counsel should consider is whether the defendants have sufficient wealth to respond to a favorable judgment.[36] If the defendant is impecunious and/or the parties elect to look to liability insurance to satisfy a settlement or judgment,[37] the plaintiff may suffer substantial dilution of recovery as a result of the need to file two lawsuits (one against the defendant and one against the defendant’s insurer).[38] Plaintiff’s counsel has a fiduciary duty to the plaintiff to explain this dilution to the client at the outset of the liability dispute.[39]

Who Gets What Part of the Pie?

“For love of money is the root of all evil.”[40] Policyholders and plaintiffs negotiating to settle and sue procedure usually have very hard negotiations of specific terms of settlement.[41] Although a plaintiff has suffered a genuine loss for which just compensation is due, frequently the policyholder has also suffered a loss at the hands of the insurer such as unpaid costs of defense. Usually, the cooperation of the policyholder and the plaintiff will be required to successfully sue a defaulting insurer. While contractual claims are assignable, personal claims for emotional distress and punitive damages are not.[42] The policyholder and the plaintiff may waive conflicts of interest pursuant to Rule 3-310 and agree to be represented by just one lawyer in a suit against a defaulting insurer. Alternatively, they may require separate counsel, each of whom will require payment of their fees and costs from a joint recovery against the defaulting insurer. The more lawyers involved, the greater the likelihood that conflicts will arise.

While a punitive damage claim can increase the value of a recovery from a defaulting insurer by three to five times the amount of compensatory damages,[43] punitive damages are often disregarded in settlement negotiations. Emotional distress and punitive damages claims are payable only if the insurer is guilty of bad faith. Insurers are reluctant to recognize such claims in settlement negotiations because of adverse regulatory consequences.[44] Accordingly, policyholders and plaintiffs may benefit from by trying to resolve as many potential points as contention as early as possible, including:

• As between the policyholder and the plaintiff, who will be entitled to how much in settlement or after judgment?

• Which lawyers are entitled to how much for past work?

• Which lawyers are entitled to how much for future work?

• Who will represent whom in the future?

• How will emotional distress and punitive damage claims be valued in settlement?

• What tax consequences befall the policyholder and the plaintiff in settlement or judgment?

[4] “The claim is made that the assignment [pursuant to a settlement to which the insurer did not consent] violates the policyholder’s duty to cooperate with his insurer in defending the lawsuit. Certainly the assignment sharply affects the policyholder’s motivations. As a potential target of personal liability exceeding the policy limit, his defensive interests were closely allied with the insurer’s. Having executed an assignment, he may relax into neutrality or even smile benevolently upon the plaintiff’s efforts. ¶ The requirement of cooperation by the policyholder assumes that the insurer has complied in good faith with the conditions of the policy (Jensen v. Eureka Casualty Co., 10 Cal.App.2d 706, 708.)” (Critz v. Farmers Ins. Group (1964) 230 Cal.App.2d 788, 801 (Critz) (ellipsis omitted, emphasis added).)

[19] “Of course, as stated some years ago by Judge Cardozo, a cooperation clause may not be expanded to require the assured ‘to combine with the insurer to present a sham defense.’” (Valladao v. Fireman’s Fund Indem. Co. (1939) 13 Cal.2d 322, 329.)

[27] “To be sure, a stipulated or consent judgment which is coupled with a covenant not to execute against the insured brings with it a high potential for fraud or collusion. ‘With no personal exposure the insured has no incentive to contest liability or damages. To the contrary, the insured’s best interests are served by agreeing to damages in any amount as long as the agreement requires the insured will not be personally responsible for those damages.’ . . . Given the accuracy of these observations, a stipulated judgment should only bind an insurer under circumstances which protect against the potential for fraud and collusion. ¶ However, most of the cases which have dealt with this problem, and have found that a stipulated judgment was not binding on the insurer, have been cases where the insurer had not abandoned the insured, but rather had provided a defense and had refused to consent to the settlement.” (Pruyn, supra, 36 Cal.App.4th at 518.)